Exchange Rate Determination Models

Determination of the exchange rate is as simple as the determination of price of any commodity or product or service. Only thing, here the commodity itself is one currency, so price of one currency in terms of another is required. But the caveat is determination of price of any commodity/product/service is not that simple. The determinants of the exchange rate are too many to consider. Yet certain macro variables would capture the same.

1. Flow Model

The flow model of exchange rate determination simply is based on demand and supply of Forex. Demand for foreign exchange takes place whenever a country imports goods and services, people of a country undertake visits to other countries, citizens of a country remit money abroad and whatever purpose, business units set up foreign subsidiaries and so on. In all these cases the nation concerned buys relevant and required foreign exchange, in exchange of its own currency, or draws from foreign exchange reserves built. So the demand side includes importers, citizens undertaking outward travel, remittances against foreign services obtained, outward foreign debt servicing, export of capital for overseas investment, buying of Forex by monetary authority as an intervention strategy, etc.

2. Current Account Monetary Model

The model assumes that: There is only one asset that is money. Domestic money is held by residents of the country and foreign money by foreigners only. Purchasing Power Parity theory holds good. There is stable demand for money in each country. Demand for money depends on real income and nominal interest rate. Foreign real income and nominal interest rate are external variables not influenced by domestic factors. Fully flexible exchange rate system is followed keeping the exchange rate in continuous equilibrium. With these assumptions the equilibrium exchange rate in ‘direct quote form: